BAD DEBT OR BAD LUCK: A PRIMER ON THE CASE-DRIVEN ANALYSIS OF BUSINESS VS. NON-BUSINESS BAD DEBTS

The Internal Revenue Code (IRC) allows taxpayers to deduct losses from bad debts in calculating taxable income. Bad debts can be classified as business or non-business, and this classification has important consequences. Business bad debts can be deducted in full against ordinary income, and deductions for partial worthlessness are allowed. Non-business bad debts must be totally worthless, and are deductible only as a short-term capital loss, subject to an annual limit of $3,000 against ordinary income. Whether a bad debt is business or non-business is a facts and circumstances determination driven largely by caselaw. This article provides an up-to-date summary of the current state of the case law related to the business or non-business classification. Several general principles are discussed, followed by an analysis of six commonly encountered issues. For these issues, we provide a detailed discussion of the factors used to resolve the classification issue. The six issues discussed are (1) when a shareholder lends money to a corporation; (2) when the taxpayer claims to be in the business of lending money; (3) when the taxpayer claims to be a promoter of a corporation; (4) when the taxpayer claims that the loan was to protect employment; (5) when the taxpayer claims the loan was to protect a source of income or business relationship; and (6) when the taxpayer claims the loan was made to protect a business reputation. The IRS is frequently successful in cases where taxpayers are attempting to treat a bad debt as a business bad debt. This paper will help taxpayers plan to structure their loans so that business bad debt treatment is supported wherever possible. Although no one makes a loan with the expectation that it will result in a bad debt deduction, it is important from a planning perspective to consider this issue at the time the loan is made.